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The Failing Logic Of Lowering Interest Rates

If Neville Chamberlain were alive today, he would be an economist instead of a diplomat. He would be creating jobs instead of peace. He would champion the Federal Reserve line that we need low interest rates to stimulate the economy.  He would get off the plane with the Beige Book to proclaim: “We have jobs in our time”.

The common economic analysis says that low interest rates spur investment which creates the jobs that are needed to drive the economy.  Unfortunately, this economic myopia works only in the world of academia where it is possible to hold the world ceteris paribus and keep the forces of unintended consequences in the footnotes. 

The basic flaw in this economic model is that it assumes that all investment is good and that resources put to work were idle. The model works well when an unemployed person borrows to open a business which is profitable enough to repay the loan. The model works less well as the quality of the investment erodes, or the resources employed were drawn away from productive uses.   For example, it is possible that lower interest rates will encourage a good baker to become a bad house flipper.  Does that help the economy?

What economists need to explain is how the economic transfers actually make the economy better. Lower interest rates transfer economic activity from the future to the present. It transfers wealth from lenders to borrowers.  It transfers demand from unleveraged purchases to leveraged purchases. But how does all of this economic activity help the economy? 

Interest is the cost of money over time and risk.  Lowering the cost of money today means that you will push demand forward, getting people to buy things today that they would have bought in the future. This demand comes from somewhere. It is shifted from other current demand, or it is brought forward from the future to the present. When I buy a $30,000 car today on leverage, it is $30,000 of purchases of other things that I am not making in the future. Debt is not spurring the economy.   It is borrowing prosperity from the future.
It is the purchases ‘not made’ that economists never factor into a ceteris paribus model. Economists focus solely on the borrower who invests the money, but they forget that for every dollar of interest saved someone has lost a dollar of payment.   The bank is not a lender, but rather a conduit to the lender which may be an 85 year-old retiree. When the Federal Reserve lowers interest rates by 90%, it is effectively cutting the pay of the 85 year-old retiree. It is cutting the pay of businesses which no longer enjoy the patronage of the 85 year-old retiree.
This activity will help the economy only to the extent that the borrower spends the money more wisely than the 85 year-old retiree would. This is a pretty dubious assumption given that the interest rates are a function of risk. So lowering interest rates encourages marginal borrowers to open businesses which would not exist under a normal interest rate structure. In the case where lower interest rates encourage a good baker to become a bad house flipper, the economy is going to be hurt. 
One should ask what will happen to these businesses once the interest rate structure normalizes. As the cost of funds rises, will these new businesses survive? Some will not, and you have to ask how does it help the economy to have someone leave a productive job to start an unproductive business that ends in bankruptcy? 
It is economically unreasonable, if not counter-intuitive, to suggest that desensitizing the users of capital from the cost will lead to a better economy. To suggest that the lowering the cost of money is good for the economy is no more reasonable than saying that lowering the cost of bread will help the economy.   In this case, the buyers of bread win and the bakers of bread lose as people buy more bread. The bakers of muffins lose as more people eat bread than muffins. There are winners and losers, but the problem with the logic isn’t in the winners and losers – it is in the bread crumbs. If you lower the cost of bread people, both consumers and producers, will leave more crumbs.
To illustrate the ‘bread crumbs’ of capital that are lost to lower interest rates, drive to any new housing development. There are 5 or 6 where I live. While these developments serve different markets and different pricing points, they all have one thing in common – no workers and no occupants. If you call the realtors you get the same story – we are waiting for the market to turn. It is only possible to hold these economic assets inactive because of the internal cost of funds at the bank.
The owners of capital have no reason to pick-up the ‘bread-crumbs’ when interest rates are .25%.   People will let the penny jar grow. What is the point of putting them in a bank when the rate is .07%? 
One of the inescapable ends of lowering interest rates the way is a rising foreclosure rate.  Levered assets will flow over time the lowest cost of funds just as water runs down hill. If the marginal homeowner pays 6% and the bank pays .25%, the cost of owning the home by the bank is fractional compared to that of the homeowner.   The bank will hold real estate longer, and be less willing to renegotiate existing loans. There is nothing in that outcome that helps the economy. 
The whole point of lowering interest rates isn’t to improve the economy. It is to give the voting public a nearterm feel-good number that makes them think that the economy is turning around. The fact is that all of what we are doing is making the crisis worse and last longer than it should.